Managing Risks: The bank-able isn’t always invest-able

The appropriateness of MFs investing in illiquid corporate bonds has been pulled into sharp glare, yet again.

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Updated: Mar 12, 2019, 09.03 AM IST

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It is important for all stakeholders to be vigilant though, in order to ensure, paraphrasing Bulgakov again, that Manuscripts don’t burn – manuscripts being investor confidence in this case!

By Somnath Mukherjee

The IL&FS default in September 2018 brought the issue on the frontburner. Issues with Loans Against Shares (LAS) bonds of the Zee and Anil Dhirubhai Ambani (ADAG) group promoters since the beginning of 2019 kept the fires burning. The appropriateness of mutual funds (MFs) investing in illiquid corporate bonds has been pulled into sharp glare, yet again.

This has been seen several times before – in recent years with MF investments in Amtek Auto, several NBFCs, certain housing-finance companies etc.

Over the past few years, the government and regulators have been trying to diversify sources of systemic credit away from traditional sources like banks (and NBFCs). MFs have been a resounding success story of that effort. Fixedincome MFs manage over Rs 11lakh crores in AUM today, and offer a significant alternative to corporate borrowers.

There is a fundamental issue though – what is bankable credit need not necessarily be “investable” instruments, because banks are fundamentally and structurally different from mutual funds.

CAPITAL MISMATCH ISSUEIt is important to understand the basic issue around MFs donning bank hats while making investment decisions. To start with, banks are heavily capitalised institutions (compared to MFs). For every ?100 loan extended, it has to upfront set aside ?9 as capital.

Further, loan loss provision norms start kicking in the moment the loan starts developing material signs of stress. As a result, banks tend to have capital cushions and buffers to handle loan losses when they happen, which also gives them the flexibility of evergreening loans should they think the stress is merely situational and temporary.

Conversely though, MFs have no such capital buffers. When they invest in a bond, it is out of unitholders money parked with the fund. Consequently, if there are delays or defaults in any bond, the net asset value (NAV) of the fund needs to be marked down to reflect the economic reality.

However, post a delay or default, if an MF decides not to mark down the NAV appropriately, but evergreens the bond (bank-style), it is leaving open multiple questions of appropriateness and fairness.

Without provisions or capital buffers, evergreening represents hope of a future resolution. If the resolution does not come through and finally the fund has to take an NAV markdown, investors who exited the fund till the markdown happened would end up being subsidised by investors who decided to keep being invested in the fund.

THE LIQUIDITY MISMATCH ISSUEBank loans are structurally and inherently illiquid.

On the other hand, bank deposits (including fixed deposits) are almost fully liquid and available on call at all times.

To manage this liquidity mismatch, banks have structural buffers built in – permanent capital (in the form of equity), central bank reserves (in the form of Cash Reserve Ratio), minimum levels of risk-free securities (in the form of Statutory Liquidity Ratio).

These allow banks to continue honour reasonable “calls” from their depositors while maintaining an otherwise illiquid loan book.

MFs, on the other hand, have no such buffers. Open-ended MFs are available on call to its unitholders for redemptions. If investments made by the MF are in illiquid assets, claims by unitholders (redemptions) during periods of even a very minor stress could be difficult to meet.

Selling liquid parts of the MF portfolio to meet redemptions leave existing investors even more vulnerable to future shocks. Above all, even at AAA/AA levels of the corporate bond market, liquidity tends to dry up very quickly during periods of stress.

This means there are significant risks of snowballing impact of even minor unitholder exits during a stress situation.

VALUATION ISSUESBecause of the illiquid nature of the corporate bond market, the fundamental variable of the MF, its NAV often rests on nebulous estimates of bond prices.

First, many corporate bonds are thinly traded, which means that the traded prices are not an accurate reflection of the real price that would be discovered by an investor if/when she hits the market with a meaningful (to her) order.

Second, for many other bonds, even an imperfect market price is absent. This leaves MFs to value those bonds according to theoretical valuations provided by ratings agencies. Like any mark-tomodel exercise, this exposes the MF to significant tail risks in price discovery – models seldom manage to price in real price impact during periods of macro (or micro) stress.

The issue again is posited against the open-ended nature of the MF instrument. Unitholders have a call on the MF for daily liquidity basis a specific published price (the NAV), while the price itself stands on very nebulous legs.

Fundamentally, not all risks that can be underwritten by banks (or lending institutions) can be invested into by MFs. Long periods of benign credit environment, high fund inflows have forced certain types of perhaps-bankable-but-not-investable investments into the MF universe.

In his classic The Master and Margerita, author Mikhail Bulgakov says that absurdities will always exist, and putative cures might themselves have absurdities that are worse than the original condition.

Thankfully, in this case the cure need not have the same absurdities as the condition – SEBI’s “sidepocketing” rules, eg, provide a good regulatory solution to some of the issues.

It is important for all stakeholders to be vigilant though, in order to ensure, paraphrasing Bulgakov again, that Manuscripts don’t burn – manuscripts being investor confidence in this case!